In doing so, the Fed followed its standard procedure of separating the conduct of monetary policy, which is geared to achieve low inflation and full employment, from regulatory policy that is intended to preserve financial stability. The basis for this distinction is that monetary policy should not be altered when a financial institution becomes insolvent unless it is systemically important—meaning that its failure could impact the banking system as a whole.
The catch is that while the definition of “systemically important” makes sense in theory, there are many gray areas in implementing policy.
Regulatory Response to Previous Crises
The cause of the GFC, by comparison, was the U.S. housing bust that resulted in massive losses on mortgage-backed securities. Congress enacted a $700 billion Treasury fund to purchase illiquid securities, but the proceeds eventually were used to recapitalize the largest institutions.
The Dodd-Frank legislation in 2010 was intended to end the problem of “Too Big to Fail.” It defined systemically important financial institutions (SIFIs) to be those with $50 billion or more of assets and made them subject to stricter requirements on capital and liquidity. However, the definition was changed in 2018-19, when Congress exempted mid-size institutions with assets of less than $250 billion.
This change made SVB and Signature Bank exempt from the tests that applied to the largest institutions. Subsequently, when the U.S. policymakers granted full protection for their depositors on March 12, the rationale was they were systemically important institutions. Yet, when Treasury Yellen testified before Congress two weeks later, she denied that there was blanket protection for all bank deposits above $250,000. As a result, there is confusion about what systemically important means and how protected depositors will be from bank failures.
Regulators Don't Have a Grasp on the Number of Banks at Risk
The problem now is that regulators do not know how many banks are at risk from losses on their portfolios and potential deposit flight. A study by researchers at NYU estimates that unrealized losses on bank portfolios are in the vicinity of $1.7 trillion, which is substantial considering that Tier 1 capital of U.S. banks is $2.2 trillion. However, this only matters if banks do not hold bonds to maturity. Accordingly, Professors Steve Cecchetti and Kim Schoenholtz argue that bank supervisors need to do an immediate review of the balance sheets of the 45 banks with assets in excess of $50 billion to determine their vulnerability to deposit flight.
In some respects, the closest parallel to what is happening today is the Savings and Loan (S&L) Crisis of the mid-1980s to mid-1990s, when one third of the S&Ls eventually failed. Despite this, the Federal Reserve did not have to alter monetary policy because many of the institutions were small and the closures played out over a decade. The main difference today is the deposit flight from troubled regional banks occurred in a few days, which has increased the risk of contagion.
Bank Credit is Likely to Slow
In the end, the Fed’s separation of monetary policy and regulatory policy is artificial. First, virtually every instance of major bank problems in the past fifty years has occurred against a backdrop of large interest rate increases. They are the catalyst for uncovering problems that were brewing when rates were low and credit was easy.
Second, the track record of regulators detecting problems in advance is uniformly poor. What is particularly troubling today is the failure of the Fed to act when bank supervisors raised red flags about SVB’s poor risk management. Furthermore, former Fed official Thomas Hoenig contends that risk-based capital measures did not take into account duration risk—the sensitivity of bank balance sheets to interest rate changes.
Finally, the recent developments have caused many observers to reflect on the famous saying, “When the tide goes out, you find out who is swimming naked.” The question now being asked is “Where were the lifeguards?”
A version of this article was posted to TheHill.com on April 3, 2023.
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